Working Capital: Meaning and Formula

Business owners need to regularly check the financial health of their company, and looking at the working capital is a good way of keeping track of how their business is functioning. The working capital formula is highly useful in doing so, especially when there are discrepancies found in the balance sheet. 

On the whole, the difference between the total current assets and the total current liabilities of a company is known as working capital. It is a component of the company’s total capital. In fact, working capital is a financial measure used to assess the liquidity position of a business.

For example, a company needs operating cash to meet its short-term obligations – this can be measured using the working capital formula.

Working Capital Formula

Working capital is the measurement of a business’s short-term liquidity, and it’s crucial for financial assessment, budgetary planning, and cash flow management. It is calculated using the following formula:

Working Capital = Current Assets – Current Liabilities

Here, 

• Current assets: Cash and equivalents, inventories, accounts receivable, short-term loans and advances plus marketable securities are examples of current assets, which are assets that may be utilized completely or transformed into cash in under a year.
• Current liabilities: Current liabilities are the sums of money owed by a corporation that is required to be paid within a year, including accounts payable, short-term mortgages, and accumulated costs.

The table below mentions some common current assets and current liabilities.

Example of Calculating Working Capital with its Formula

A company’s working capital can be increased by selling additional items. If the product’s:

• price per unit is ₹1,000 
• the cost per unit in inventory is ₹600

The company’s working capital will rise by ₹400 for every unit sold due to increased cash or accounts receivable.

When a company’s working capital is compared to that of its competitors in the same industry, it might reveal its competitive position. 

For example, Company A has ₹40,000 in working capital while Company B has ₹15,000 and Company C has ₹10,000 as working capital. Hence, Company A may spend more money to build its business to expand more quickly than the other two.

Types of Working Capital

An organization must maintain several forms of working capital dependent on value and frequency. Let’s take a closer look.

Working Capital – Based on Value

On the basis of value, working capital can be classified as:

1. Gross Working Capital is the amount invested in the company’s current assets, such as cash, accounts receivable, inventories, marketable securities, and short-term securities.
2. Net-Working Capital is the surplus value of a current asset after current obligations are subtracted. The net working capital formula is almost the same as the calculation of working capital. Hence, the net working capital formula includes current assets (less cash) – current liabilities (less debt)

Working Capital – Based on Periodicity

• Permanent Working Capital: This is a section of working capital that is permanently invested in current assets to continue business operations. To put it another way, permanent working capital is the smallest amount of current assets required to run a firm smoothly. Permanent working capital is further divided into two categories-

• Regular Working Capital: This is a sub-category of permanent working capital. It is defined as the smallest amount of capital a company needs to support its day-to-day operations. Distribution of wages and salaries and overhead charges for the treatment of raw materials are examples.
• Reserve Margin Working Capital: It is retained in addition to the standard working capital requirements as a reserve for covering costs in the event of unforeseen events such as strikes, natural disasters, or property damage.

• Variable Working Capital: This is described as working capital invested in a firm for a limited period. It’s also known as changing working capital. For example, sudden fluctuations in the cost of raw material contribute to variable working capital.
• Seasonal Variable Working Capital: It is the working capital that is set aside to meet peak seasonal demands. This is usually in case the business product/service is seasonal. For example, umbrellas, raincoats, woolen clothes, etc.

Working Capital Turnover Ratio Formula

It is a formula that a firm uses to see how efficiently they generate sales using the working capital.

Working capital turnover = Net annual sales/working capital.

In the above-stated formula, working capital is found by subtracting a firm’s current liabilities from its current assets.

Here, working capital is the operating capital used by a company for everyday operations. This formula is also known as net sales to working capital. This formula provides a precise idea to the company about the availability of additional money that can be put towards operations after obligations like bills and debts have been met.

Firms that have higher working capital turnover ratios run operations and generate sales more efficiently. Although excessively high ratios might be an indicator of insufficient working capital of a firm that is required to maintain the sales growth it is experiencing. A lower working capital turnover ratio of a company indicates that the operations are not running effectively. This formula can also be used to see if a company can pay off its debts in a fixed time frame and whether it will run out of cash if the production requirements increase.

Importance of Working Capital

Working capital is a simple concept to comprehend since it is tied to an individual’s cost of living and can be grasped on a more personal level. For instance, individuals must collect money owed to them and set aside a specific amount each day to pay day-to-day expenditures, invoices, and other recurring obligations. 

Here are some reasons why working capital management is critical:

• Measuring Tool

Working capital is a common statistic for a company’s efficiency, liquidity, and general health. It reflects the outcomes of numerous firm actions, such as revenue generation, debt administration, stock management, and vendor pay. 

For example, firms with an optimal level of working capital are often more efficient in their operations management. This also allows the company to pay its short-term debts and day-to-day operating costs.  

• Aid Corporate Expansion

Working capital may also be utilized to support corporate expansion without taking on debt. If the firm does need to take loans, having a good working capital position might help it qualify for mortgages or other types of credit.

• Avoid Fluctuating Revenues 

The fluctuations in the revenue can be managed by working capital. A lot of businesses go through seasonal growth as they sell more during certain months. During such incidents, with sufficient working capital, the company can make extra purchases and prepare for the upcoming busy months, all while maintaining the financial obligations during fewer revenue periods.

• Accounting Tool

Working capital regulation is essentially an accounting strategy that emphasizes maintaining a healthy balance between a company’s current assets and liabilities. Good management of the working capital system would help a company meet its financial responsibilities and increase its profits.

The Bottom Line

A company may use various operational methods to assure that its working capital is being used to its full potential. While accounting cannot forecast every aspect of operating a business, having a clear picture of working capital should help businesses run more efficiently. Marking monthly inflows and outflows for any company will help them better grasp their working capital requirements. To make sure that working capital is working for a company, the management must assess what it has currently, anticipate what it’ll need in the future, and think about how to make sure the organization always has enough cash.